The market for liability-driven investment, strategies that invest pension funds’ money so that it matches their expected payments, is in flux as 2012 draws to a close.

Pensions hold fire on matching assets

Unusual bond market conditions – such as the flight to safety and quantitative easing – have put pension funds’ strategies on hold and fund managers’ business expansion plans with them. But only for the time being.

The UK’s £1 trillion private-sector pension fund sector is where LDI has been pioneered in the past decade. Over £300bn is now managed this way, according to the most recent market survey from consultancy KPMG.

Over 85% of the total is managed by just three firms, Insight Investment, BlackRock and Legal & General Investment Management, and most of the rest is with two others, F&C Asset Management and Schroders.

But newer entrants are trying to break in (see below), including Axa Investment Management, which has hired Shalin Bhagwan from LGIM.

After years of talking about the same three firms, investment consultants, who help pick LDI managers for their pension fund clients, are now able to present fuller shortlists of providers.

Pat Race, UK head of investment consulting at Mercer, said: “The LDI market is more interesting right now than it has been for a while. A lot of my clients have historically clustered to the larger, more established and resourced players. But there is increasing interest in less well-established managers who offer execution-only LDI mandates.”

-- Competition

Rather than offering full LDI services that take care of decisions such as when to hedge and what instruments to use – whether to invest in physical gilts or the swap contracts based on them, for example – smaller players have built teams to liaise with consultants and implement these strategies with their input.

Race said: “What I saw a lot of clients doing initially is [asking for] active management of their hedges in interest rates and inflation. The manager would hedge a little bit more or less depending on the market. But as clients, particularly large and sophisticated clients, get more familiar with LDI they have started calling these things better.

“They set up special committees that meet monthly or even more frequently; they decide what instruments they want, with advice from their consultants. This service needs a different type of manager – an execution-only manager.”

This is a niche in the market that Schroders and F&C are well-placed to fill; managing and transacting a portfolio, but with less discretion and a corresponding reduction in fees. Consultants can recommend these services without writing themselves out of the picture entirely.

John McLaughlin, head of portfolio solutions at Schroders, said about a third of his firm’s £10bn in LDI mandates is managed in this way. But another third is in mandates that also involve managing growth assets as well as liability-matching ones, a service that approaches the all-in pension-fund investment services offered by fiduciary managers such as Cardano, which also displace consultants.

McLaughlin said: “These are both fast-growing businesses for us. We have had to learn to work with consultants in a new way – in some instances we compete with them, in others we co-operate with them.”
But all LDI managers have a common problem, which is that current market conditions are discouraging pension trustees from extending their hedges at all.

-- LDI ‘paralysis’

Thanks to a flight to safety that is still influencing the UK government debt market, coupled with the effects of the Bank of England’s gilt-buying under its quantitative easing policy, the prices of gilts are at historic highs and the yields are therefore at record lows. LDI managers report that pension trustees are loath to hedge in such conditions, believing bond markets can only get cheaper.

The marketing message from LDI firms is clear, however: there is no need for paralysis.

Market participants already expect interest rates and bond yields to rise in the years ahead, and this is priced in. In a trustee workshop during the National Association of Pension Funds’ conference in October, Axa Investment Management, one of the new entrants, pointed out that while interest-rate swaps today pay 0.5% a year, 30-year interest-rate swaps pay 2.9%.

Simeon Willis, a principal consultant in KPMG’s pensions advisory department, said: “If you think interest rates will rise in the future, that is no reason not to hedge. If you think interest rates will rise in the future by more than the market is currently expecting, that could be a reason not to hedge. But that is quite a big call.”

There are, however, also other factors contributing to the delay in pension schemes’ liability-hedging activity.

Willis said: “One of the biggest issues right now is the Office for National Statistics’ consultation on changing the way that the retail prices index is calculated. Most schemes’ inflation-linkage references RPI and the ONS is considering bringing it closer to the alternative consumer prices index, which is generally about 1% a year lower.

“If they do change it, this would mean a pension scheme’s RPI-linked liabilities would step down and funding should improve. But there is uncertainty about the outcome. It looks unlikely they will leave RPI as it is, but it’s not clear it will move fully into line with CPI.

“The market for RPI-linked securities has come down about 0.5 percentage points in anticipation, but if you think it’s likely the authorities will move RPI fully into line with CPI, you could wait to hedge inflation until you can hedge at a rate that’s 0.5 points cheaper still.”

-- If you liked Insight and BlackRock, why not try...?

A number of fund managers are trying to break the stranglehold that the “big three” and the “other two” have on the UK’s pensions LDI market. These include Axa Investment Managers, BNP Paribas Investment Partners, Ignis Asset Management, Pimco, Pramerica, and State Street Global Advisers.

Ignis Asset Management is offering a service more tailored to a pension scheme’s particular liabilities. Where a conventional pooled LDI mandate might invest in several buckets of debt securities, one full of bonds maturing in 2020 and one full of bonds maturing in 2025, 2030 and so on, Ignis’s service offers to match cashflows precisely to the year.

Helen Farrow, director of fixed-income sales at Ignis, said: “At the simplest level, we can hedge the one-year interest rate starting in four years’ time, by buying a five-year bond and selling a four-year bond.”

Derek Steeden, an LDI strategist at Ignis, said this enabled the manager to hedge different future rates whenever they were best-priced in the market.

Others have their own answers to the tricky market conditions. Pat Race, UK head of investment consulting at Mercer, said: “There is an interesting trend towards building corporate bond portfolios in the short term – removing pretty much all other ‘growth assets’ – and moving to duration-matched government bonds as a second step. I have got clients who have set up triggers to move very rapidly through this structure.”

Pramerica Fixed Income is one fund manager already profiting from this approach, according to Gary Knapp, its managing director for insurance and liability-driven strategies. Pramerica manages $8.7bn in corporate bonds, including such long-duration “buy and maintain” mandates.

He said: “LDI is much more a corporate-bonds strategy among US pension plans because they do not have the compulsory inflation linkage that UK plans do. We have a lot of money managed this way in the US, but are increasingly seeing interest in the UK too.”